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debt overhang

The entire economics world is abuzz about the intriguing smackdown between Paul Krugman and Ron Paul on Bloomberg. The Guardian summarises:

Ron Paul said it’s pretentious for anyone to think they know what inflation should be and what the ideal level for the money supply is.

Paul Krugman replied that it’s not pretentious, it’s necessary. He accused Paul of living in a fantasy world, of wanting to turn back the clock 150 years. He said the advent of modern currencies and nation-states made an unmanaged economy an impracticable idea.

Paul accused the Fed of perpetrating “fraud,” in part by screwing with the value of the dollar, so people who save get hurt. He stopped short of calling for an immediate end to the Fed, saying that for now, competition of currencies – and banking structures – should be allowed in the US.

Krugman brought up Milton Friedman, who traversed the ideological spectrum to criticize the Fed for not doing enough during the Great Depression. It’s the same criticism Krugman is leveling at the Fed now. “It’s really telling that in America right now, Milton Friedman would count as being on the far left in monetary policy,” Krugman said.

Paul’s central point, that the Fed hurts Main Street by focusing on the welfare of Wall Street, is well taken. Krugman’s point that the Fed is needed to steer the economy and has done a better job overall than Congress, in any case, is also well taken.

I find it quite disappointing that there has not been more discussion in the media of the idea — something Ron Paul alluded to — that most of the problems we face today are extensions of the market’s failure to liquidate in 2008. Bailouts and interventionism has left the system (and many of the companies within it) a zombified wreck. Why are we talking about residual debt overhang? Most of it would have been razed in 2008 had the market been allowed to liquidate. Worse, when you bail out economic failures — and as far as I’m concerned, everyone who would have been wiped out by the shadow banking collapse is an economic failure — you obliterate the market mechanism. Should it really be any surprise that money isn’t flowing to where it’s needed?

A whole host of previously illiquid zombie banks, corporations and shadow banks are holding onto trillions of dollars as a liquidity buffer. So instead of being used to finance useful and productive endeavours, the money is just sitting there. This is reflected in the levels of excess reserves banks are holding (presently at an all-time high), as well as the velocity of money, which is at a postwar low:

Krugman’s view that introducing more money into the economy and scaring hoarders into spending more is not guaranteed to achieve any boost in productivity.

The fundamental problem at the heart of this is that the Fed is trying to encourage risk taking by making it difficult to allow small-scale market participants from amassing the capital necessary to take risk. That’s why we’re seeing domestic equity outflows.And so the only people with the apparatus to invest and create jobs are large institutions, banks and corporations, which they are patently not doing.

Would more easing convince them to do that? Probably not. If you’re a multinational corporation with access to foreign markets where input costs are significantly cheaper, why would you invest in the expensive, over-regulated American market other than to offload the products you’ve manufactured abroad?

So will (even deeper) negative real rates cause money to start flowing? Probably — but probably mostly abroad — so probably without the benefits of domestic investment and job creation.

Inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.

Again, I have to bring this back to why we are even talking about debt relief. The 2008 crash was a natural form of debt-relief; the 2008 bailouts, and ongoing QE and Twist programs (which contrary to Professor Krugman’s apologetics really do transfer wealth from the middle classes to Wall Street) crystallised the debt burden born from a bubble created by Greenspan’s easy money policies. There would be no need for a debt jubilee (either an absolute one, or a Krugmanite (hyper)inflationary one) if we had simply let the market do its work. A legitimate function for government would have at most been to bail out account holders, provide a welfare net for poor people (never poor corporations) and let bankruptcy courts and markets do the rest. Instead, the central planners in Washington decided they knew best.

The key moment in the debate?

I am not a defender of the economic policies of the emperor Diocletian. So let’s just make that clear.

Paul Krugman

Actually you are.

Ron Paul

Ron Paul is dead right. Krugman and the bailout-happy regime for which he stands are absolutely following in the spirit of Diocletian.

Rome had its socialist interlude under Diocletian. Faced with increasing poverty and restlessness among the masses, and with the imminent danger of barbarian invasion, he issued in A.D. 301 an edictum de pretiis, which denounced monopolists for keeping goods from the market to raise prices, and set maximum prices and wages for all important articles and services. Extensive public works were undertaken to put the unemployed to work, and food was distributed gratis, or at reduced prices, to the poor. The government – which already owned most mines, quarries, and salt deposits – brought nearly all major industries and guilds under detailed control.

Diocletian explained that the barbarians were at the gate, and that individual liberty had to be shelved until collective liberty could be made secure. The socialism of Diocletian was a war economy, made possible by fear of foreign attack. Other factors equal, internal liberty varies inversely with external danger.

Well, I think it is fair to say even without modern data that — just as Krugman desires — Diocletian’s measures boosted aggregate demand through public works and — just as Krugman desires — it introduced inflation.

Diocletian’s mass minting of coins of low metallic value continued to increase inflation, and the maximum prices in the Edict were apparently too low.

Merchants either stopped producing goods, sold their goods illegally, or used barter. The Edict tended to disrupt trade and commerce, especially among merchants. It is safe to assume that a gray market economy evolved out of the edict at least between merchants.

And certainly Rome lived for almost 150 years after Diocletian. However the long term effects of Diocletian’s economic program were dire:

Thousands of Romans, to escape the tax gatherer, fled over the frontiers to seek refuge among the barbarians. Seeking to check this elusive mobility and to facilitate regulation and taxation, the government issued decrees binding the peasant to his field and the worker to his shop until all their debts and taxes had been paid. In this and other ways medieval serfdom began.

Have the 2008 bailouts done the same thing, cementing a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

I have mentioned, in passing, the possibility of transforming debt into equity as a solution for many of the troubles in the global financial system.

I borrowed the idea from Nassim Taleb and Mark Spitznagel, who floated it in 2009. It is unfortunate that the idea has not yet been taken very seriously. There are probably two reasons for this: firstly Taleb and Spitznagel never fully fleshed it out, and secondly because the political and media punditry don’t really recognise the graveness of the present situation. Largely it is hoped that we can muddle through; radical solutions tend to get left on the shelf.

It is my view that it is much better to fix the system in a fundamental way, rather than clobber together solutions piecemeal. The latter approach has been the norm — from the bailouts of Greece and euro austerity, to the bailout of AIG and the wider financial system, to quantitative easing and LTRO, to Obama’s stimulus package — the focus has been on keeping a system that is falling apart at the seams from crumbling completely into dust.

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. The $18 billion that Greece owes to the banks are in turn owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more. The great cyclical wheel of international debt is only as strong as its weakest link. This kind of breakdown is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

The concept of too big to fail — and thus the justification for all the bailouts — comes out of these default cascades; if a default were to trigger such a cascade, the cycle of payments would break down. Thus, the logic goes, if a bankruptcy would break the system, then the government should step in and prevent that bankruptcy. Thus, the system can continue operating. Alas, this is the road to a zombie economy. If bad companies can succeed just as easily as well-run ones, then the market mechanism is rendered meaningless. Why innovate and create when instead you can run on government largesse? Why seek efficiency when inefficiency gets you cash just as easily? Furthermore, this government largesse starves new businesses of opportunities and cash. Every dollar taxed to pay for bailouts is a dollar that could have instead been invested in a startup. And every juggernaut that is saved is a hole in the marketplace that could instead have been filled by a new and better company.

The problem then, is the huge overhanging cyclical structure of debt and interest. In a free market — without bailouts and largesse — it would have collapsed into the sand long ago. That would have been painful and contractionary, but after the storm there would have been aggressive new growth; without the debt overhang, new lending would have been easier. There would be holes in the market to fill. But governments have determined that it must be saved, that there is no alternative to this strange mess.

It is not good enough to imagine a new beginning, either. For we already have this mess, and we have to get out of it. A route out — toward a place where the system is no longer so fragile. If we ignore the mess, our route out of it will be messy — systemic collapse, currency crises, trade breakdown, war or worse.

Now, I believe that the most significant factors in robustifying society are economic, as opposed to financial. The West’s greatest fragilities stem not from its weak financial system, but from its energy dependency and susceptibility to energy costs (for example, the financial crisis in 2008 might never have been so severe had there been such a huge spike in energy costs), its deteriorating infrastructure, and its imperial largesse (the cost, the blowback, the shortage of manpower). Simply, if America and the West were fuelled by decentralised domestic energy production (e.g. solar), and decentralised local production and resource extraction, the ululations of the global financial system would be irrelevant to the common people.

But, in reality, we live in a globalised and interdependent system. So anything that might robustify the financial system would be welcome.

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.

The strongest advantage, though, goes unmentioned. Systematically transforming debt into equity would end the problem of financial entities being too big to fail, as failure would no longer lead to a breakdown in the debt cycle. This is because insolvent positions would simply default to a majority-minority equity position, and — if the debtor’s equity position were high enough, say about 33% — liquidation could be avoided.

A huge philosophical problem is that such a complete transformation would alter (violate?) a huge number of existing contracts. It would be a top-down and coercive solution, and that is always open to legal challenge. Furthermore, curtailing the issuance of debt means curtailing the freedom of society and individuals to enter into any contract seen fit.

But the larger picture is rather intriguing — in a world where all debt has become equity, there is no such thing as a default, because an equity position is one of ownership, and thus a claim on future earnings.

Simply, lending would be done through lenders buying a share in a person or company’s or government’s future earnings, rather than through creating debt. Loan contracts could still be structured precisely the way they are today. But, as Taleb and Spitznagel insinuate in saying that “banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity”, lenders would have much more of an incentive to assist in the development of their equity position, as this would surely be the best way to get back their initial investment. And — as an equity position, rather than a cast-in-stone lending contract — terms could be far more easily renegotiated.

Of course, this new system would surely pose a whole new universe of challenges and moral and regulatory quandaries, not least the moral and philosophical problems of government effectively banning debt-based lending.

But, if we are looking to avoid the moral hazard of bailouts, and the dangers of default cascades, the architects of the global financial system — including banks themselves, who could of their own volition choose to cease debt-based lending, and adopt equity-based lending — could do much worse. While systematically transforming debt to equity is too difficult and controversial (not least for contractual reasons), we must remember that in a purely free-market, all of those debt-based lenders would have gone bust a long time ago.